Markets brace for a key inflation test

Markets

Wall Street traders appeared to be sitting on their hands at the start of the week, lacking serious motivation to keep pushing the rally wagon higher. An inflation test looms before the next Federal Reserve gathering, which could sway guidance.

It is imperative to avoid a repeat of the last CPI release. Another report similar to January’s could raise doubts about the Fed’s rate cut wisdom in 2024. If the inflation dragon shows up again, it will not sit well with risk appetite.

The prevailing sense of wariness has been amplified by signs of return dispersion among the esteemed "Magnificent 7," reaching unprecedented levels. This serves as a reminder of the risks that emerge when valuations reach extreme levels, and the trend of following the leader takes a step back.

At the bullish end of the prism, NVDA has returned an impressive 87% year-to-date, fueled by its robust Q4 earnings report and sustained investor optimism surrounding AI. Meanwhile, at the opposite end of the bearish prism, Tesla appears to be running on empty, facing challenges and uncertainties affecting its performance.

Amazon, Meta, Microsoft, and, obviously, Nvidia have done quite well in the latter case. On the other hand, Alphabet, Apple, and Tesla, the anvil, are dragging down the group. With the Mag 7 effectively being reduced to the Mag 4 these days, it is more difficult to immerse oneself in bullish vibes, given how heavily each individual stock is weighted at the index level.

Measures of risk appetite, meanwhile, are not extreme; the various risk barometers periodically make a run at exuberance, but concerns could build if we see deeper negative return dispersion among the highly vaunted Magnificent 7,

One would be hard-pressed to suggest Monday's malaise is related to any “hard “ macro-driven event given Friday’s Goldilocks job report; instead, it feels like a case of good old risk management taking hold until we clear the US inflation report. Still, any signs of a rate cut spark on thawing CPI price data could return those “animal spirits” quickly.

However, a spanner in the works could be that Americans’ inflation expectations rose last month, according to the new vintage of the New York Fed’s consumer survey, released on Monday.

That’s not the best news for a Fed looking for any excuse to cut rates in June.

Inflation's psychological component can lead to self-fulfilling expectations. Hence, policymakers strive to anchor consumers' outlook on price growth, but that didn’t happen.

Measures of risk appetite, meanwhile, are not extreme; the various risk barometers periodically make a run at exuberance, but concerns could build around return dispersion among the highly vaunted Magnificent 7

Japan Markets

The Bank of Japan (BoJ) is contemplating a significant policy decision that could affect the sizzling Japanese stock market rally. There is growing speculation that the BoJ might consider ending its negative interest rate policy (NIRP) and raising interest rates shortly. This move could impact investor sentiment and cool down the arguably overheated Japanese stock market.

The recent gains in Japanese equities raise questions about the underlying drivers behind the rally. It's possible that these gains were driven more by factors like a weaker Yen and the ubiquitous rally pump rather than a strong belief in the fundamentals of the Japanese economy. If this is true, investors may need to reassess their positions in light of a less accommodating policy environment and stronger Yen, which could shine a less favourable light on the nation’s export behemoths. Indeed, it will be a keen litmus test for traders chasing the hottest global market, amplified by local currency weakness and an exodus of money for China, where the latter shows signs of life again.